2007 June. Tom Corcut Economic Advisor. Defra. EU Emissions Trading Scheme ETG Update

Today’s Competitiveness Update  Brief overview of UK’s Review process.  Introduce Key analytical studies for the review process  Introduce Climate strategies interim report competitiveness.

Review of the EU ETS – Timeline schematic Ma y 07 Jun 07 Jul 07 Aug 07 Sep 07 Oct 07 ECCP WG Publishes Report to Commission 28June? Anticipated Date for commission Legislative Proposal ECCP WG Harmonisation & Predictability May ECCP WG Linking Jun Commission Review Member State Discussions Env Council discussion 28 June Env Wkg Group 8 June Jan 07 Nov 07 Dec 07 Environment Council Commission drafting Interservice consultation & impact committee MS negotiation of Aviation in ETS Proposal Informal MS mtg on Cap etc 15 May Berlin Informal MS Meeting (Linking/sinks) 6-8 June Poland Troika Ministerial 21 May Warsaw European Parliament Plenary on aviation in EU ETS Proposal 4 June Troika Ministerial Lisbon ECCP Working Group Discussions MS Negotiation of Directive

OCC/Defra Review Project  Improved data on which to base debate in UK and across EU: including: Climate Strategies Oxford Economic Forecasting  Framework of UK policy objectives underpinning UK Emissions Vision Statement of October 06  Initial stakeholder views in response to issues paper

Who are Climate Strategies? Climate strategies are an independent group of experts and researchers attempting to suggest solutions to the collective action problem of climate change. Funders (alphabetical order) BP. Carbon Trust Defra DTI Dutch Ministry of Economic Affairs. Statoil. Swedish Ministry of Sustainable Development.

The Climate Strategies interim report Source: Oxford Economic Forecasting analysis Starting point: Fear that policies applied to domestic energy-intensive sectors facing competition from firms located in regions without climate policies could reduce international competitiveness, in terms of market share and profitability. However, in general little empirical evidence to support the hypothesis that climate policy has adversely affected competitiveness. 3 main factors determining inherent potential to EU ETS: Energy intensity. ability to pass cost through to prices; and abatement opportunities.

The Climate strategies approach Leakage - constraint on ability to pass CO2-related costs on to customers is foreign competition from regions outside the EU - simplest measure = existing degree of trade intensity. Intra EU Comp - trade intensity within the EU gives an insight into the potential degree of concern regarding differential allocations between countries. The research suggests that differentials in the level international exposure to international trade and net value at stake imply that potential competitiveness impacts widely differentiated across sectors.

The Climate strategies approach However, most Phase I & II NAPs treated all sectors in the same way, by allocating according to BAU. Means that some sectors more over compensated than others. The CS work considers the impact of EU ETS on the Net Value at Stake for a sector (NVAS): Value at stake = (increase in total costs after allowance allocation)/ (starting earning before interest, depreciation and amortisation)

Impact of non-EU Competition on ETS sectors Source: Climate Strategies analysis

Impact of EU Competition on ETS sectors Source: Climate Strategies analysis

The Climate Strategies interim report – part II. Part II considers the differentiation between products in a sector and quantifies the impacts for sub-sectors: The analysis suggests that sector level analysis can mask important differences between competitiveness impacts within a sector. Relatively few sub-sectors are found to stand out in terms of the impact on Net Value at stake. These tend to represent the basic commodities in each sector, where energy and CO2 intensity is high relative to other input factors. Other than in iron and steel, the sub-sectors that are exposed to CO2 prices only contribute a small share of total sector GVA.

The Climate Strategies interim report – part III. Part III looks in depth at the steel and cement sectors (EU level analysis). Conclusions: Profit margins in the cement sector more sensitive to rates of free allocation than steel. A €30 carbon price, a zero rate of free allocation in the cement sector could reduce the profit margin to zero, whereas 75% free allocation could be sufficient to almost double profit margins. In the steel sector, a €30 carbon price and zero free allocation could reduce profit margins by around 20% and 100% free allocation could increase margins by around 20%. In both sectors, the rate of free allocation required to maintain the profit margin in the counterfactual (with a €30 carbon price) is around 50%.

The Climate Strategies interim report – part III. Conclusions: The analysis finds that the rate of free allocation required to keep profit margins constant falls as the carbon price increases. Results from the fact that at higher carbon prices the value of free allowances is higher and this more than compensates for the additional cost increases. Sensitivity tests show that the compensating rate of free allocation is highly dependent on the assumption on the level of pass through

The Climate Strategies interim report – part III. Conclusions: If a strategy to minimise the likelihood of reduced profitability was considered desirable, assuming the central assumption of 50% cost pass- through, an 80% rate of free allocation in both sectors results in a profitability loss with a probability of just 20%. This level of free allocation may well therefore lead to windfall profits. The research concludes that competitiveness impacts are likely to be relatively smooth and it is unlikely that there will be some carbon price ‘tipping point’ i.e. a price above which international pressure would increase dramatically, leading to large market share losses and/or zero cost pass-through ability.

Next Steps: Milestones  Climate strategies final report due in the autumn.  UK outline policy framed June/July  Continuing dialogue with ETG, LCCS, NGOs and industry beyond ECCP during July-November  Discussion with Commission and Member States over same period  Formal Written Consultation  Commission Proposal by Year End and negotiating of detail with Member States and EP begins